These Metrics Spot Signs Of ETF Failures

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the industry. Today's article is by Patrick Flannery, founder and CEO of MayStreet, which specializes in cutting-edge market-access and data analytics software.

With the number of exchange-traded funds continuing to grow at what some across the industry call an “unsustainable” rate, a new trend is beginning to attract attention: the risk, if not rise, of ETF closures.

As of the start of September, 83 ETFs had closed so far in 2016, according to ETF.com, putting ETF closures on pace to beat the 99 closures the site listed for last year.

Investors appear to be taking notice. On Seeking Alpha, an “ETF Deathwatch” column written by registered investment advisor Ron Rowland has more than 38,000 followers. Investors who want to avoid the hassle (not to mention the reinvestment risk) of investing in a fund that may have a high risk of closure increasingly need to evaluate ETFs not only in terms of their performance, but in how viable the strategy may be.

Assets Not The Best Closure Indicator

For more than a decade, the number of ETFs has grown at a staggering pace. An industry that had 284 ETFs globally in 2002 had swelled to a total of 4,426 ETFs in by the end of last year, according to London-based ETFGI, with total global investment in ETFs and ETPs now topping $3 trillion.

While large, frequently traded, highly liquid ETFs have a low risk of being shut down, lower assets under management alone is far too broad a factor to be indicative of potential closure risk.

Investors interested in niche strategies need to look for signs of how well constructed an ETF is to better assess its strength and staying power.

Tracking efficiency is a key metric that may well offer greater insight into the strength or weakness of an ETF strategy.

Impact From Illiquid Underlying Trades

For example, how well does the ETF track its benchmark index? While most ETFs have both liquid and illiquid components, it can be useful to evaluate how significantly these components impact the overall ETF basket, because not all ETF components may trade in a day, or even in a week.

Other concerns: When the less liquid ETF components trade, how large are those spreads? And what impact do those illiquid trades have on the overall ETF basket?

An ETF with unusual volatility of volume profiles could contain highly volatile or illiquid components that contribute to large spreads. Consistent tracking metrics such as one-minute averages of intraday net asset value (iNAV), and average minimum and maximum values per month, can offer further insight into the liquidity of an ETF in comparison with its underlying components.

Carrying Costs Also Play A Part

The carrying cost of an ETF may also be a factor in ETF adoption. For some of the nontransparent ETFs, there’s a rather wide distribution in costs. An ETF with a significant carrying cost may experience lower adoption, because investors might view it as too expensive in comparison with other ETFs with comparable strategies.

As an investor, you need to understand how to evaluate the actual expense and cost ratio of an ETF in comparison with similar investments.

Not all ETFs are designed to be highly liquid. To truly understand the significance of ETF size and trading volume, you’ll eventually need to dig deeper into understanding implied liquidity.

Again, for example, how much volume can an ETF’s components support? It’s entirely possible that some ETFs have a sweet spot in terms of their adoption and trading volume.

Reverse-Engineering

By analyzing factors such as how many ETFs a stock is in and how much of a stock’s volume is supported by the ETF, you can dissect and reverse-engineer an ETF.

These metrics can present a clearer picture of how large an ETF even has the capacity to become, while still retaining its ability to closely track its strategy.

However, in such a vast industry, there are thousands of ETFs with less than $25 million AUM that are in no risk to shut down.

Tracking and analyzing the liquidity of ETFs in comparison with their components can uncover aberrations in volatility and spread patterns.

By tracking consistent metrics and scoring ETFs based on factors such as liquidity statistics, volumes, actual costs and underlying correlations, we believe you can gain not only a new perspective but much-needed insight into ETF quality.

At the time of writing, the author held no position in SPY. Patrick Flannery directs the product vision of MayStreet, which specializes in cutting-edge market-access and data analytics software for latency-sensitive capital market firms.